With economic clouds darkening, many investors are re-assessing their asset allocation. But almost every year since 2008 has involved a crisis for investors in European private equity, some with local roots, some global. There has been the Great Financial Crisis, the Eurozone debt crisis, Russia’s annexation of Crimea, Brexit, threats to global trade, covid and more.
But double-digit returns have been earned by European private equity investors in every single vintage year over this period (figure 1), whatever the European economy and global markets have thrown at them, recessions included.
More recent years’ performance are less meaningful as funds have yet to mature but investors in 2008-17 vintages have earned an average internal rate of return of 16% a year, and got back an average of 1.8 times their money. This has far outpaced GDP growth.
One reason why performance has been so resilient is that private equity funds benefit from “time-diversification”. Capital is deployed over several years, rather than all in one go. This reduces sensitivity to market events and means that the concept of market timing doesn’t make sense when it comes to allocating to private equity. Likewise private equity investors are long-term asset holders without pressure to divest if market conditions are not conducive to return maximization.
Rather than being a time for investors to worry about allocating to private equity, recession year-vintages have actually been a pretty good time to invest. It is easy to understand the intuition behind this: funds raised in bad times can pick up assets at depressed values as a recession plays out, and then exit later on in the recovery phase when valuations are rising. Even if 2022 and 2023 are tough market environments for exits, they may be good opportunities to pick up appealing companies on more attractive valuations.
There is also the fact there are many value-drivers that go well beyond European economic or domestic industry-specific growth. For example, mergers and acquisitions/consolidation, technical innovation, professionalisation, and export-oriented business models. These can generate value even against a challenging macroeconomic backdrop.
But a tailwind from rising leverage and falling borrowing costs is ending
One factor that has been supportive through this period is cheap, easily available debt. This has helped more leveraged transactions “juice” returns, especially when accompanied by rising valuation multiples. Looking forward, this looks set to go into reverse. Debt will cost a lot more and leverage levels will be lower – both because capital will be less freely available and also because higher interest costs will make it less appealing.
But, offsetting this, falling valuations mean that it costs less to acquire a company today than it would have done 12 months ago. And, the price reduction required to offset a lower level of leverage and leave returns unchanged is less than you might think. A 12.5% reduction could be enough to offset a reduction in leverage from 65% to 50% without impacting returns, all else being equal (see worked example).
One change is that the types of strategies that look set to be more successful could look quite different to those that succeeded in the past decade. With leverage and rising multiples unlikely to propel returns, there could be a sweet spot for strategies focussed on revenue growth and profit margin improvement.
For example, expansion of product lines or geographic footprint, and professionalising management to improve profit margins. This is all easier to do among small- and medium-sized, often family-owned, companies. At larger companies, which have often been through several rounds of private equity or institutional ownership, it is much harder to add the same value.
Buy and build strategies are also well positioned to do well, with opportunities to buy smaller companies, expand, improve profitability and then sell at the valuation premium that larger companies go for compared with smaller ones.
Crudely, let’s assume a company’s enterprise value grows by 8% a year. So if it’s worth €100m on day 1, it’s worth €146.9m after 5 years (for the purpose of this analysis it is irrelevant whether this comes from revenues, margins, or multiple expansion). At that point it is assumed you exit.
If the purchase is 65% financed by debt, then that covers €65m, with the equity investor putting up the other €35m. After 5 years, the equity investor’s stake is worth the sale price net of outstanding debt which, for simplicity, I’ve assumed is still €65m. That gives them €81.93m, which works out as an annualised return of 18.5% on their initial €35m investment.
But what if, in today’s new world, you can now only get 60% debt financing. Or 55%. Or less? Figure 2 shows how much cheaper the purchase price would need to be for your return to be the same as in the original case. This assumes you can still sell it for the same projected value of €146.9m in 5 years’ time. For example, if only 50% debt financing was available, entry prices would have to fall by 12% for investors to still earn an 18.5% return. This is perhaps less than many people might expect.
What about inflation risk?
The other worry on many investors’ radar right now is inflation. A combination of labour market tightness, ongoing supply chain disruption, and the war in Ukraine have all contributed to soaring prices. This is a global problem which is affecting all asset classes, across equities and bonds, public markets and private ones. Private equity is not immune. As well as impacting leverage, as described above, many companies’ profitability will come under pressure as their cost base increases.
However, not all will suffer. Those which are able to pass on higher costs into higher prices will prove more resilient. Those with weaker market positioning or whose products and services are more easily substitutable will struggle. This will increasingly differentiate between successful companies and successful private equity investors in the years ahead.
Investors in European private equity need not fear an economic downturn. There are always problems in Europe as in other regions of the world. But returns have been strong through thick and thin. The tailwind from cheap interest rates may be fading but the ability to buy companies for less will go a long way to offsetting that. Funds focussed on smaller and medium-sized companies look to be particularly well positioned to navigate the times ahead.